The discretionary performance convergence problem

Figures from ARC’s private client indices show a significant narrowing of the difference between the best and worst performers with the bottom percentile of the ARC Sterling Cautious PCI managing an average return of 0.8%, compared to the best managers’ 1.5%.

A similarly pronounced effect was shown in the ARC Sterling Balanced PCI, where the top quarter managers returned 1.9% while the laggards provided a 1.2% return.

The close similarity of best and worst performing managers in each risk bucket is far more apparent for the last quarter of 2012 than at any other point over the last three years.

Since 2010, managers in the cautious sector returned 15.8%, some way ahead of the 11.4% return made by the poorest performing managers.

Daniel Hurdley, director at Asset Risk Consultants, said there were several factors at play. First, the macroeconomic environment has increased the correlation between asset classes, leaving managers less room for manoeuvre.

‘There has been quite a high correlation in returns among many of the asset classes. So where a manager may have diversified away from equities into other risk assets, they have seen a very similar return to equities,’ he said. ‘Thus, differences in asset allocation have not necessarily led to large differences in returns.’

‘The second factor is the liquidity bubble driven by high levels of quantitative easing, which has made bond markets very unattractive to managers. Combine this with the relatively low returns available from cash and hedge funds and in terms of the strategic asset allocation of the portfolio there hasn’t been a lot of room for differentiating performance versus another manager.’

How have certain managers outperformed?

However, while the high correlation of assets has made it difficult for managers to stand out, those who were first to play some of the most successful themes did outperform.

‘An example of this would be the high quality, global brand-type equity strategies, which have been a very crowded trade for investment managers,’ Hurdley said.

‘The managers who have done better are those that pursued that trade earlier than most, particularly those managers who have a more stock-picking oriented approach versus a broad top-down exposure to equities over the same period.’

Managers have also achieved differentiation by selective stock-picking, rather than buying funds.

‘The only place they could differentiate themselves is in the timing and implementation of their asset allocation decisions – for example if they are investing in equities, a more concentrated stock selection versus funds in the same space,’ Hurdley said.

He noted that use of derivative overlays has also become much more prevalent.

While markets and macroeconomics have shoe-horned managers into similar strategies, this situation is unlikely to be permanent. Advisers outsourcing to investment managers should think carefully about the manager’s allocation style, as when markets normalise this will be the main determinant of any differentiation they show in future, Hurdley said.

‘It’s important to understand the investment style because if you are looking at performance you will see similar returns but what will happen when things change?’

Don't focus on benchmarks

Haig Bathgate, chief investment officer at Turcan Connell, agrees that knowing the managers’ underlying investment style is vital. ‘It’s really important to understand this because otherwise you don’t know if you’re paying for alpha or style bias – and the latter can be done at a very low cost via passives.’

Bathgate believes the lack of divergence in returns is partly an extension of the risk-on/risk-off environment, although it is also due to managers focusing on relative rather than absolute returns.

‘We try not to think about benchmarking too much,’ says Bathgate. ‘We think about what we are doing for our clients, and if you have this mind-set, you are less likely to get caught up in the herd mentality. What is happening is a symptom of the way the industry is approaching money – with the general view that it’s better to be conventionally wrong than unconventionally right. There is a fear of reputational loss.’

For example, he says, many investors were avoiding Europe during the eurozone crisis, because they were concerned with managing money relative to the peer group and benchmarks.

He adds that there is increasing short-termism in the industry and that it is important to focus on the long-term goals. ‘We had a hedged Japanese yen position, but this took 18 months to come through in terms of returns,’ he said. ‘People are sticking too much to benchmarks.’

Although assessing managers’ styles is of utmost importance, this is both time-consuming and difficult.

‘It is terribly difficult for private clients or even trustees who might see a number of houses in action, to really form an intelligent view on how different managers’ styles could really lead to a divergence of returns,’ said Francis Nation-Dixon, a partner at Adams and Remers.

Pension funds have the advantage of actuaries dealing with these sorts of issues, as they are able to make underlying investment changes without incurring capital gains tax.

‘With private clients, they face capital gains tax constraints, so it’s harder to compare like for like,’ said Nation-Dixon. ‘These are also smaller portfolios, so dealing costs will have a much greater impact.’

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